Despite its high exposure to trade, Malaysia continued to enjoy a relatively strong rate of expansion in 2012. Soft global demand for manufacturing exports and volatile palm oil prices failed to dent domestic consumer confidence. The local corporate sector and households powered ahead with spending, while government investment plans were supported by an accommodative monetary and fiscal environment, even as momentum in Asia’s biggest economies began to fade, with Europe and the US showing weak signs of recovery.
FIRM COMMITMENT: Being an election year, 2012 was expected to bring popular measures, elements of which were visible in the 2013 budget unveiled at the end of September. Overall, however, executives interviewed by OBG were positively surprised by the detailed follow-through offered in the Economic Transformation Programme (ETP), the development blueprint. “In contrast to previous plans, this one is extremely detailed and pragmatic, with a strong focus on delivery,” Stephen Hagger, Malaysia country head at Credit Suisse, told OBG. “The level of regular consultation and follow-up with key sector participants has been impressive.”
The microeconomic approach to development seems to be paying off in the short term. The Asian Development Bank (ADB), along with many foreign analysts, revised its forecast following stronger-than-expected performance in early 2012. “Driven by strong consumption and investment that benefitted from fiscal stimulus, economic growth was higher than projected in the first half of 2012. Robust domestic demand overrode weakness in exports,” the ADB concluded in its report in the second half of 2012. In light of this, “GDP growth will outperform the previous forecast. Growth is seen edging higher in 2013, but the forecast is trimmed from April owing to downgrades in global prospect.”
REBALANCING: Notably, recent performance is underpinned by an ongoing rebalancing of growth towards domestic sectors. A steady increase in consumption and investment helped sustain GDP expansion rates at close to pre-crisis levels of 5% per annum. Meanwhile, credit growth remained brisk despite financial stress in the global banking system, with Malaysian banks supporting consumers through retail loans, although the central bank moved to tighten lending standards.
Domestic resilience has been highlighted by a number of high-profile initial public offerings, with palm oil producer Felda making international headlines as one of the few successful listings not just in Asia but globally in 2012. International investors were also reminded of the strength of Malaysian balance sheets when state-owned oil and gas company Petronas attempted a $5.3bn takeover bid for Canadian gas producer Progress Energy Resources. Similarly, the country made international headlines when a consortium made up of Malaysian firms SP Setia and Sime Darby was chosen as the preferred bidder for the Battersea Power Station project in London. This agreement was one of the landmark deals in real estate in 2012 globally.
CONSUMPTION: Another source of economic rebalancing came from higher domestic consumption of goods and services. After a period of slow growth, private sector consumption rose by 8.1%, buoyed by a strong labour market, higher wages and government support for household incomes. Traditionally low unemployment rates declined further, from 3.4% to 2.8%, while wages in the manufacturing sector rose by 6% in the first half of 2012, boosting purchasing power. The government continued to play a key role in pushing up incomes, with the Public Service Department issuing a circular stating that public sector wages would be raised by 7-13% in March 2012 (13% for grades 1-54 and smaller raises for higher grades). The government also increased pensions and introduced direct cash handouts to low- and middle-income families. Meanwhile, the $3.2bn sale of Felda shares acted as an indirect stimulus, given that 112,000 families, largely from low- and middle-income segments, enjoyed a one-time payment following the sale of the firm on the bourse.
From a structural point of view, consumption is supported by a steady rise in the middle class. According to CIMB Bank research, 42.4% of Malaysia’s 6.4m households are in the middle-income category as of 2012, and this group plays an increasingly important role in the rebalancing of the economy. On the downside, CIMB expressed concern that low- and middle-income groups have to cope with the rising cost of living. “Skyrocketing property prices in recent years have made home ownership less affordable,” the bank reported. The main concern, according to CIMB and shared by the IMF, is that while savings remain high, there is a rise in debt among some lower-income groups that have become vulnerable to income and interest rate shocks.
DOWNSIDE RISKS: The main concern for investors remains to what extent recent growth momentum is sustainable over the next two to five years. Executives still regard the government as being opposed to the private sector as the pacesetter of expansion. There is a medium-term risk that the public sector’s ability to spend and invest will face constraints.
Standard & Poor’s was the first international ratings agency to signal concern that the current expansion is, to a certain extent, achieved at the cost of adding risk onto the state’s balance sheet. Malaysia’s gross general government debt in 2012 will increase to 53.9% of GDP, up from 51.9% in 2011, Standard & Poor’s said in a report published on September 5, 2012. That figure is higher than any country in the A- rating category except Israel and Poland. Fitch Ratings said on August 8, 2012 that it was “Concerned that negative pressures may build and eventually offset the existing strengths of the sovereign credit profile unless structural weaknesses in the public finances are addressed.”
For a country with an A- rating, Malaysia may be building long-term liabilities faster than it can generate new productive assets. The predominant view is that the added value of state spending is hitting diminishing returns, as most productivity gains in infrastructure and technology have been achieved. In the short term, however, analysts agree that putting the brakes on state spending would have serious consequences. It could send the economy into an avoidable recession, with a major negative impact on consumer and investor confidence. In the longer run, analysts interviewed by OBG are hoping to see a clear strategy on widening the tax base to fund social expenditure, with the current reliance on the oil and gas sector for 30% of government revenues, along with expenditures related to generous subsidies, seen as unsustainable.
ROOM FOR MANOEUVRE: Few foreign or domestic analysts think that Malaysia faces any significant macroeconomic risks over the next 18 months. Short of another major global recession, Malaysia is expected to achieve growth of close to 5%, with a steady shift to domestic consumption and investment helping to cushion the economy against external shocks.
“Healthy financial and corporate balance sheets, ample foreign exchange reserves and room to further loosen monetary policy would help contain the impact of an external shock on the financial sector and the economy,” the IMF said in its February 2012 country report on Malaysia. “There is room to cut policy rates, provide both foreign exchange and domestic currency liquidity, and allow the exchange rate to act as a shock absorber.” On the issue of structural deficits, analysts point out that these are largely funded by domestic savings, which at over 30% are among the world’s highest. Thanks to supportive monetary policy borrowing costs have reached historical lows, with the government able to issue bonds to the local market at a cost of 2%. Malaysian corporations – a number of them linked to the government – also enjoy access to cheap funding. A combination of improved demand and falling costs of financing, as well as a slew of state projects, has helped lift private investment from historical lows. Fixed capital investment increased 21.3% in first-half 2012, more than three times the rise seen during the same period in 2011. For the first time in many years its contribution to GDP surpassed that of private consumption.
INFLATION EXPECTATIONS: Inflationary expectations are firmly anchored, with Malaysia enjoying the lowest rate in South-east Asia at 2%, compared to 5% in Indonesia and 11.5% in Vietnam. Price pressures and volatility are regarded as well under control thanks to Bank Negara Malaysia’s prudent monetary policy, which has managed to keep inflation stable for several decades, protecting the purchasing power of the ringgit. “Under the baseline, inflation is expected to continue to moderate, and the current monetary policy remains appropriate,” the IMF concluded in its report.
According to Tony Pua, a member of Parliament for Petaling Jaya Utara and a leading commentator on the country’s economic challenges, the numbers can be misleading. “Headline inflation numbers don’t tell the full story. The consumer price index basket doesn’t reflect accurately the consumption of Malaysians, with real prices actually rising. If we win the elections, we will address this concern by changing the composition of the basket,” he told OBG.
In the meantime, the government’s subsidies, which remain in place, help to absorb the excess price volatility of key transport, fuel and food items. In its latest report the IMF sees headline inflation at 2.5% on average, with limited material impact stemming from disruptions to rice production in neighbouring Thailand. The main inflationary risks in the long run are seen as a permanent increase in the price of oil and continued pressure on food supply. While the government is not expected to phase out subsidies during an election year, it remains under pressure to pass on the real cost of energy to consumers. Given the social implications, the transition is expected to be sufficiently protracted to create a significant rise in the rate of inflation.
EXCHANGE RATE POLICY: As the IMF has pointed out, a flexible exchange rate regime provides another source of macroeconomic stability. At $119bn, the country’s gross official reserves are estimated to be enough to cover 6.2 months of the following year’s imports. Despite ongoing volatility in the financial markets and some pressure on emerging market currencies, Malaysian policymakers did not see any need to use capital controls, with traditional monetary policy tools judged to be adequate to reduce volatility. Policymakers also allowed market forces to dictate the pace of the ringgit’s appreciation against the dollar, due to expectations of monetary easing in both China and the US. Although this is putting pressure on exports, in line with other central banks in South-east Asia Malaysia resisted the temptation of competitive devaluation.
SURPLUS COUNTRY: Although Malaysia continues to be a net capital exporter to the world, the overall current account balance is expected to enjoy a healthy surplus. The overall balance for 2012 is projected to reach 12.1% of GDP, with the trade surplus at $47.8bn, compared to $47.4bn in 2011.
The downside from growth in investment and consumption is that imports have risen faster than exports, with the overall current account balance likely to shrink in 2012. According to Lee Heng Guie, lead analyst at CIMB, export recovery will continue to be weak in 2013. “With the external environment remaining inhospitable, an export recovery will likely remain distant. Based on 8M12 sub-par export growth, we tweak our export growth estimate for 2012 lower to 2-3% from 3-4% previously (9.2% in 2011) while maintaining a 4-5% growth forecast for 2013,” he said in a research note in October 2012. While higher growth in imports compared to exports will have a negative net trade impact on GDP, a large share of imports are capital goods, which are needed to boost the productivity of the economy.
GROWTH IN NUMBERS: The first half of 2012 turned out to be particularly encouraging to those who feared another manufacturing export-led slowdown. According to official statistics, the economy expanded by 5.1%, bettering initial consensus expectations, with the year-end forecast revised upwards to 4.5-5%. This is slightly slower than in 2011, when GDP growth reached 5.1%, but is widely viewed as realistic by foreign analysts, with risks to this outlook broadly balanced.
However, with the domestic contribution to overall GDP already seen as being close to its maximum potential, the growth trajectory in 2013 will depend on the recovery in Europe and the US, with prospects still hazy due to the ongoing debt crisis in the eurozone and the fragile recovery in the US. The government has been cautious in communicating official growth forecasts, conscious of unpredictability in the global economy, which plays a bigger role in Malaysia’s GDP than is the case for most ASEAN countries. Malaysia’s exports of goods and services, for instance, exceeded 100% of its GDP in 2012, compared to just 30% in Indonesia. Although the total share of exports to advanced markets has been declining over the last few years, Malaysia remains more vulnerable to global downturns than other ASEAN nations, with the exception of Singapore.
COMPARATIVE VIEW: The official growth forecast for 2013 revealed by the prime minister during his budget speech on October 28, 2012 has been set within a range of 4.5-5.5%, while ADB has revised its 2012 year-end forecast from an initial 4% to 4.6% after stronger than expected domestic demand in first-half 2012. However, this forecast is lower than the 5% published in April, in light of subdued international outlook.
Malaysia’s economy has posted an average rate of expansion of 5.7% since recovery began in 2010. It is expected that by 2013 nominal GDP will exceed the symbolic threshold of RM1trn ($323bn), with GDP per capita reaching RM36,000 ($11,600). According to the IMF, GDP in purchasing power parity terms is now among the top 30 in the world, and the third-highest in Southeast Asia. In terms of headline growth numbers, Malaysia is set to underperform some of its neighbouring economies in ASEAN, such as Indonesia, Vietnam and Cambodia. This is partly because these less-developed countries are rising from a far lower base, enjoying relatively easy technological productivity gains. Malaysian corporates are in fact set to benefit from growth in ASEAN, with a number of banks, telecoms, transport and construction firms in a strong position to profit from the growth stories in Indonesia and, later, Myanmar.
Malaysia’s main challenges will be to position itself as the gateway to the ASEAN community in financial services, and to integrate its economy in the regional supply chain. Already a regional leader in financial services, manufacturing of electronics and electrical goods (E&E), palm oil, transport and construction, Malaysia has yet to face up to productivity challenges in automotives and food processing, with some of its ASEAN neighbours enjoying cost and technical know-how advantages in these sectors.
PERFORMANCE DRIVERS: Of the countries in the South-east Asian economic area, Malaysia currently stands out as the most active in developing a new growth strategy that goes beyond resources and manufacturing. The New Economic Model (NEM) and the detailed ETP represent a clearly formulated top-down plan to introduce new growth drivers (see analysis). Given that room for further fiscal expansion is limited, the success of this approach will depend on how quickly the private sector will respond to government initiatives and become an autonomous engine of growth.
Much to policymakers’ delight, the growth momentum appears to be driven by the private sector, as was intended by the 10th Malaysia Development Plan (10MP) launched in 2010. It is too early to call it a definitive success given how little data there is since the ETP was launched. However, a 25% surge in private sector investment in the second quarter of 2012 – after five consecutive quarters of strong performance – suggests the initiatives are indeed having a tangible impact.
The Malaysian corporate sector, which has until recently been predominantly outward-looking, has now been persuaded to allocate larger amounts of capital for domestic opportunities, mainly in areas identified under the ETP’s 12 National Key Economic Areas (NKEAs). Similarly, there has been renewed interest from foreign investors in a series of entry point projects (EPPs), which were designed to kick-start areas of high-value-added activity in the NKEAs.
FISCAL DEPENDENCE: The main challenge is to make sure that the increase in household consumption goes hand-in-hand with rising private sector investment and productivity growth. Despite its recent performance, the private sector in Malaysia is not yet an autonomous engine of growth, according to most economists interviewed by OBG. Malaysian corporates and foreign investors remain dependent on strong government leadership and co-investment in strategic projects. Without the fiscal reform and efforts to expand the small tax base that relies heavily on revenues from the oil and gas sector, the government could run out of fiscal room, with the debt-to-GDP level already close to the statutory 55% limit. To avoid breaching this self-imposed cap the government could decide to sacrifice infrastructure and entry point investment spending, which in turn could undermine private sector investment growth.
INCLUSIVE GROWTH: Raising Malaysia’s potential growth will necessitate further development of human capital, and the IMF also points out that extra efforts are needed to make growth more inclusive through investment in the social safety net. Instead of blanket subsidies, the organisation has proposed a more targeted approach to social spending to support the needy segment of the population. “An unemployment insurance scheme and expanded pension provision could be designed without a large fiscal cost,” the IMF said.
Arguably the biggest challenge currently facing Malaysian policymakers is that, by their ambitious standards, the economy is not growing fast enough to meet the expectations of its population, with some economists arguing that the country is showing signs of being stuck in a “middle-income trap”. Although 5% average annual growth is an enviable statistic for most countries in Europe these days, Malaysia’s recent economic performance does not compare favourably to, for instance, the 9% average growth achieved in 1988-96.
The development blueprint Vision 2020 launched by former Prime Minister Mahathir Mohamad in 1991 saw Malaysia set out its aim to reach advanced economy status in 30 years. This has become a political imperative and the main strategic intention of every development plan that followed.
Most recent studies indicate that Malaysia will need to grow at an average annual rate of around 6% for the rest of this decade to reach the target of $15,000 per capita income. For comparison, the current level is around RM31,000 ($10,000). Although income levels have risen by 24% since 2009, recent indicators suggest that the economy’s growth trajectory is under pressure, with the annual GDP expansion rate more likely to be 5% on average than the required 6%.
While rising levels of foreign direct investment (FDI) will help to support growth (see analysis), development of the small and medium-sized enterprise (SME) segment in particular will also be crucial, according to Hafsah Hashim, the CEO of SME Corporation Malaysia. “Malaysia must bear in mind that domestic companies are where the true dynamism of any economy is created; FDI serves as a buffer, rather than the primary engine for growth,” Hafsah told OBG.
STRUCTURAL HEADWINDS: The economy still faces a number of structural headwinds, despite a concerted effort by the government to move the country to the next stage of development under the ETP. Heavy reliance on export manufacturing, commodities and the energy sector means that Malaysia is still vulnerable to external demand shocks.
Competition from new low-cost destinations in Asia, such as Vietnam, Cambodia and, to some extent, Indonesia, is putting Malaysia’s traditional manufacturing sectors, such as E&E, under pressure. The increase in labour costs over the years has made the previous low-cost manufacturing model unsustainable, and there are few easy avenues available to replace old engines of growth. Having benefitted from resource-based growth early on and then from manufacturing in the 1970s and 1980s, Malaysia must transform itself into a knowledge-based economy. Having invested heavily in infrastructure and low-cost manufacturing, the country’s best option is to move first into value-added service and downstream sectors at first in already existing supply chains such as chemicals, automotives and palm oil.
While the economy has ample of capital available to invest in acquisition of knowledge and technology from abroad, there is a shortage of available labour and skills to support this transition.
QUEST FOR TALENT: As was pointed out by Danish economists Daniel Fleming and Henrik Søborg, who published a paper entitled “Malaysian Skills Development and the Middle-Income Trap”, “a successful outcome of these projects depends on… recruitment to the educational sector, particularly vocational and tertiary education, and… upon the reshaping of skills and upgrading initiatives.” The government has long identified this as a key issue, as spelled out in a self-critical fashion in the NEM, which admitted: “We are not developing talent and what we do have is leaving.” Unleashing the creative innovation required by the knowledge economy has been the main pillar of the ETP.
There are signs in 2012 that the efforts to transform the economy are starting to pay off, but also that the pace of transformation is too slow to deliver the goals of 2020 because of labour marker rigidity and legacy issues of preferential treatment of the local Malay population, according to critics.
While quite frank in acknowledging the challenges facing the 10MP, some argue that the plan underestimates the daunting task of transforming attitudes and acquiring skills in education and science. Especially in research and development (R&D), many market participants regard the top-down approach as being well intended but often ineffective, and feel that market forces rather than government should decide which projects are viable. R&D expenditure in Malaysia remains low at 0.6%, compared to 2.3% in Singapore and 3% in South Korea, with Malaysia lagging behind these Asian frontrunners in terms of patent applications.
TRANSPARENCY: Transparency remains a challenge as well, with Malaysia ranking 60th worldwide on Transparency International’s 2011 Corruption Perceptions Index with a score of 4.3. This puts it above less-developed regional rivals like Thailand (3.4, 80th), Indonesia (3, 100th place) and Vietnam (2.9, 112), but well below neighbouring Singapore (9.2, 5th) and Australia (8.8, 8th). Efforts are being made to address this, however. Abu Kassim Mohamed, chief commissioner of the Malaysian Anti-Corruption Commission, told OBG, “Malaysia is considering the establishment of a unit modelled after the Office of the Inspector General in the US Department of Justice to further solidify anti-corruption efforts and enhance conduct.” Long waiting times for corruption cases is another problem, according to Abu Kassim. “The average duration for corruption trials in Malaysia is 8.5 years. To improve upon this, the backlog first needs to be cleared. This can only done through the creation of special corruption courts.”
OUTLOOK: Malaysia is by no means immune to external developments, with its economy still vulnerable to events in both Europe and the US. However, the ongoing transition towards local and regional sources of growth should help reduce the impact of another downward shift in demand in 2013.
Growth in 2013 is expected to moderate to below 5%, according to consensus forecasts. The target of 6% annual growth will be difficult to reach given the current trade environment, but there is upside potential on further growth in private investment and consumption. Just like in 2012, growth momentum in the next 18 months is expected to be driven principally by the government’s project initiatives, with EPPs in NKEAs, especially in business services, of great importance in attracting both domestic and foreign investors.
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